Lehman Brothers Holdings Inc., the fourth largest US investment bank, succumbed to the subprime mortgage crisis in the biggest bankruptcy filing in history. The 158-year-old firm, which survived railroad bankruptcies of the 1800s, the great depression in the 1930s, & the collapse of long-term capital management a decade ago, filed for chapter 11 bankruptcy on the 15th of September 2008. 2. Impact of the crisis: how it led to the collapse of Lehman Brothers In this segment, we will review the media stories covering Lehman Brothers during the crisis and present the impact of the crisis on Lehman Brothers in the form of a timeline, right till its eventual bankruptcy.
In 2008, Lehman faced a loss for the first time since going public as the subprime mortgage crisis unfolded. Lehman’s loss was ostensibly a result of having held on to large positions in subprime and other lower-rated securitized mortgage tranches. In the first half of 2008 alone, Lehman stock lost 73% of its value. Notably, in the second quarter of the financial year 2008, Lehman reported stupendous losses of $2.8 billion. As a result, it had to sell off $6 billion in assets in order to meet its debt obligations.1 In August 2008, Lehman announced that it would relief 6% of its work force. We look how things unraveled in the few days prior to their collapsed.
10th September 2008
Lehman released bleak third-quarter results and drew attention to the fragility of its financial position. It reported a loss of $3.9 billion that included a write-down of $5.6 billion.2 In order to raise much needed capital, Lehman Brothers had to sell off its asset management subsidiary, Neuberger Berman. That same day, Moody’s Investor Service reported that it was re-assessing Lehman Brother’s credit ratings and also said that Lehman Brothers would need to sell a majority stake to a strategic partner in order to avoid a ratings downgrade. Thus, Chief executive Dick Fuld desperately searched for buyers with plans to sell off assets3. Meanwhile, investors were nervous about whether the US government would bail Lehman out as the government had previously bailed out major lenders Fannie Mae and Freddie Mac.
11th September 2008
The state-controlled Korea Development Bank who was in the midst of acquiring Lehman Brothers, withdrew due to “difficulties pleasing regulators and attracting partners for the deal.”4 The news was a deathblow to Lehman Brothers and caused a 45% plunge in its stock and a 66% spike in credit-default swaps on Lehman’s debt.5 The company’s hedge fund clients began to pull out, while its short-term creditors cut credit lines. The frantic search for buyers raised doubts over the bank’s survival and its shares plunged 42 percent to $4.44.
12th September 2008
Barclays announced that it was considering bidding for Lehman in an attempt to bolster it presence in North America. Despite the apparent interest, Lehman shares dropped 13.5 percent. The US government began talks with Wall Street bankers to come up with a solution on methods to rescue Lehman Brothers. Tim Geithner, the New York Federal System Reserve (FRS) president, proposed ‘good bank, bad bank’ solution.6 This would allow buyers to take on Lehman Brother’s good assets, with Wall Street stumping up to cover for its US$80billion of toxic debts.
14th September 2008
Over 100 top Wall Street bankers along with regulators and the US Treasury officials spent the weekend in the Federal New York building exploring options. After its US$229 billion in bailouts for Bear Stearns, and Fannie Mae and Freddie Mac, the US Treasury was unwilling to part with more taxpayer money.
15th September 2008
Wall Street and the US Treasury were unable to come up with a solution and Lehman Brothers was left to fend for itself. It eventually filed for chapter 11, bankruptcy. With US$639 billion in assets and US$613 billion in debts, it is the largest US corporate bankruptcy. It was also the first major bank to collapse since the credit crisis began a year earlier. Lehman bonds and loans that were trading at 80 cents to 90 cents in the dollar the week before were now worth little more than 40 cents.7 About $70 billion of Lehman Brother’s debt held by other institutions was wiped out and holders of that debt faced huge potential losses.
As of September 2012, Lehman emerged from bankruptcy, and now looks very much like a normal investment bank. The only difference is that Lehman’s sole objective is to sell everything it owns so that it can repay its lenders and disappear.8 We will move on to explore the causes that led to the collapse of Lehman Brothers. 3. Causes of the problems faced by Lehman Brothers in the crisis The main cause of the 2008 financial crisis was the boom of the housing market in 2004 fuelled by low interest rate and easy financing. During this time, Lehman Brothers obtained mortgage lenders and subprime lenders BNC Mortgage and Aurora Loan Services. Its real estate business segment recorded revenues in the capital markets that increased by 56% in the period from 2004 to 2006. In 2007, the housing market begins to show signs of slowing down with defaults in the subprime mortgages at a seven year high. While most financial institutions were affected, Lehman Brothers was majorly exposed in the financial crisis. In the next segment, we determine the underlying causes of the problems faced by Lehman during the crisis.
3.1 Over-concentration in the mortgage market
Over-concentration in the mortgage market was one of the primary reasons that led to the fall of the Lehman Brothers. From 2006 till mid-2007, Lehman aggressively expanded into commercial real estate, private equity and leveraged lending using its own capital (Latifi, 2009). In 2007, it underwrote even more mortgage-backed securities and built up a portfolio of $85 billion that was four times larger than its shareholders’ equity. Even when it recognized the risk from the mortgage market, rather than pulling back, Lehman doubled its holdings in illiquid investments from $87 billion in 2006 to $175 billion at the end of the first quarter of 2008, hoping to profit from a counter‐cyclical strategy (Saurav K. Dutta, 2010). This over-concentration in the mortgage market made it especially vulnerable and sensitive to a downfall in housing price. When the housing prices fell, for the first half of 2008 alone, Lehman stocks lost 73% of its value. (Sourcewatch, 2012)
3.2 High leverage
Overly high financial leverage was another cause that led to the demise of Lehman Brothers. Leverage is the ratio of total assets to shareholders equity. In Lehman Brother’s case, attention was not paid to its risk management. While the maximum leverage for Wall Street broker-dealers was held to be 20 to 1, Lehman Brother’s leverage ratio increased from 24 in 2003 to 31 in 2008. To make matter worse, Lehman Brother relied heavily on short-term debt financing (Robyn Alman, 2009), which meant Lehman was under stupendous amount of insolvency risk should short-term lenders cut credit lines. As the financial crisis unfolded, borrowers began losing confidence and called back the loans they gave Lehman. As Lehman was highly leveraged, they did not have the cash to pay back the loans and had to resort to selling off its assets. As majority of Lehman’s assets were illiquid, this led to fire-sale risk and liquidity problems for Lehman (Saurav K. Dutta, 2010).
3.3 Overvaluing Collateralized Debt Obligations9 (CDOs)
The over-valuation of CDOs added to liquidity problems at Lehman Brothers in 2007 and in 2008 and punched a hole in Lehman’s balance sheet during the crisis. This over-valuation was caused by three factors. Firstly, the “product control group”, a unit of Lehman whose job was to double-check valuation of assets held by trading desk, lacked the resources to comprehensively price test the CDO positions. The employees of the unit lacked the quantitative knowledge that the traders had and deferred to the traders’ model when valuing the assets. Secondly, third-party prices were used to evaluate Lehman’s positions on only 10% of the CDO portfolio and did not provide an accurate measure of the CDO’s value. Lastly, Lehman Brothers was using inaccurate discount rates to value projects.
On its largest CDO position, a product called Ceago, Lehman used a lower discount rate for the riskier subordinate tranches than it did on the senior tranches, which is exactly opposite to how it should be as senior tranches are considered safer securities. It was reported that estimated prices for certain tranches are approximately one‐thirtieth of the price reported by Lehman that indicated a gross overvaluation on Lehman’s part. (Carney, 2010) As the financial crisis unfolded with increased defaults on subprime mortgage, CDO positions were massively written down due to overvaluation. Investors became nervous about their exposure to such assets and stopped investing in Lehman Brother’s commercial papers (Latifi). Withdrawal of their funds adversely impacted Lehman Brothers, as it was unable to roll over or renew their commercial papers that led to liquidity problems and eventually insolvency.
3.4 Fraud: Manipulation of accounting statements
Another reason that led to the downfall of Lehman Brother was the manipulation of its accounting statements to temporarily remove up to $50 billion of assets from its balance sheet in order to deceive the public about its true liquidity condition (Adam, 2010). Lehman made use of Repo 10510 to reduce its liabilities. Repo 105 is an accounting maneuver where a short-term loan is classified as a sale. 11The cash obtained is then used to pay the company’s liabilities hence reducing its financial leverage such that it can reflect a healthy liquidity condition on its published balance sheet (Agatha, 2011). Shareholders were concerned with the financial leverage of the company since a higher debt level would mean higher risk to them. Lehman did not adequately manage this and took on risky investments and activities.
It resorted to Repo 105 in an attempt to hide its unhealthy financial situation (Pranvera, 2010). Repo 105 transactions often increased just before the quarterly reporting period so as to reflect a favourable state of its finances with a healthy leverage (Agatha, 2011). Lehman’s failure to disclose information regarding the Repo 105 transactions to significantly lower its leverage, created a misleading portrayal of its true financial health. With this, Lehman Brother deceived the public about their true liquidity condition, and committed a major fraud eventually leading to their bankruptcy. However, this bankruptcy may have been prevented if Lehman Brother’s external auditor Ernst & Young had raised concern about the use of Repo 105.
3.5 Certified public accountants (CPAs)
Ernst & Young (E&Y) had allegedly failed to question and challenge improper or inadequate disclosure in Lehman Brother’s financial statements. Even though E&Y insisted that the financial statements were presented in accordance with the Generally Accepted Accounting Principles, the reduction of 0.9 in the gearing ratio12 for the second quarter of 2008 was significantly material and the audit firm should have been alarmed by the excessive use of Repo 105 (Steve, C). In fact, there were claims that E&Y only approved the accounting treatment applied to the transactions and did not consider their overall impact on the financial statements, and the real reason why it was used (Karen, 2010). The lack of consideration for the materiality and examination of any Repo 105 transaction did not seem to meet the professional standards to which auditors adhere. E&Y’s inaction allowed Lehman Brothers to continuously engage in manipulation of its accounting statement that contributed to its downfall.
3.6 Credit ratings of mortgage-backed securities
One of the reasons which led to Lehman Brothers’ failure was its massive investments in subprime mortgage-backed securities rated too highly by rating companies like Moody’s, Standard and Poor and Fitch. The credit rating agencies inflated the credit worthiness of the subprime market and understated the risk involved in thousands of subprime mortgages and the companies holding the debt for these (Amanda, 2010). They played a key role in creating the dire market conditions by underestimating the complexity of the financial instruments in the market. Many of the subprime mortgages were rated Aaa and Aa1 ratings (Moody’s golden standard) right before they folded due to countless defaults and this adversely affected the companies that had invested in them (Kevin, 2010). Lehman was one of them. In fact, the entire financial industry that had counted on the accuracy of the credit ratings was affected with their investments in these subprime mortgages.
3.7 Government Regulations
The Commodity Futures Modernization Act of 2000 introduced deregulation of over-the-counter derivatives that was at the heart of the 2008 financial crisis. It prohibited the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) from regulating derivatives trading by this legislation (Lynn, 2009). SEC was only allowed limited oversight of swaps and otherwise relied on industry self-regulation. In particular, Lehman was a counterparty to or guarantor of over 930,000 OTC derivatives and the lack of regulation eventually resulted in their inability to honour their derivative obligations that contributed to their insolvency (Monetary Authority of Singapore, 2012).
3.8 Bad Corporate Governance
The corporate structure was one of the reason Lehman Brothers failed. Lehman Board of Directors was made up of a number of members who did not have the past financial markets expertise. CEO Richard Fuld decided all company’s risk management, strategies, goals and objectives. The Board of Directors was highly ineffective, as they did not have control over the company. The chairman of the board and the head of risk committee was both Richard Fuld and this will lead to inherent self-interest risk and independence risk which caused the delay in recognizing the mortgage crisis as Richard Fuld autocratic rule failed to take into account other inputs.
Furthermore, due to its autocratic corporate structure, there was a lack of communication and common understanding in the company where warnings from talented researchers and managing directors regarding the massive risks under mortgage transactions were ignored and dismissed (Robyn Alman, 2009). As such, management was too slow to recognize Lehman’s need to raise capital and shed bad assets that eventually led to liquidity problems. Having determined the underlying causes of problems experienced by Lehman Brother, we will explore possible measures that could have been taken to avoid these problems.
4 Explore how the problems may be avoided
The study of history and the eventual collapse of Lehman Brothers will help us learn the mistakes made by them and the measures we could have taken to avoid the problems.
More accountability could have been placed on management towards its shareholders in order to mitigate the issue of moral hazard. The concept of equity pay structure for employees is to make every employee feel like an owner of the company and for each employee to act responsibly in their decisions as their income would be tied up with the long-term value of the company. Instead, system of risk and reward ratio backfired in the Lehman Brothers case. The equity pay structure had in fact provided a strong incentive for employees to recklessly take on higher leverages and pursue high profits. Therefore, companies should control the risk to reward ratio in the equity pay structure for employees. Companies should continue to reward employees with equities, but perhaps the percentage of equities rewarded in relation to their overall performance should be reduced.
The subprime mortgage crisis came at the time when Lehman Brothers had a huge stake in it, holding a large portion of its investments in the subprime mortgage market. From the definition of subprime mortgage it explains how risky such investment is. Thus, while holding such risky assets can reap supernormal returns during the boom of the housing market, it can result in drastic losses when the housing market underperforms. Figure 3 illustrates that in 2006 Lehman Brother was the largest underwriter for securities, worth over $51.8 billion and by September 2007, 20% of the subprime loans were in default. On the rise of this crisis, Lehman Brothers made a loss of US$2.8 billion in the 2nd quarter of the 2008 financial year. This loss could have been offset if they had diversified their portfolio.
Marketers believe that financial innovation, for the sake of producing something new, sometimes doesn’t increase value, but instead ends up destroying value. Here, we are referring to the relatively new financial securities at the heart of the crisis. Namely, credit default swaps (CDS), Mortgage backed securities (MBS), Collateralized Debt Obligations and derivative of derivatives (CDO2). Instead of selling corporate or government bonds, equities and other financial instruments that customers could readily understand, Lehman Brothers brought to the market complex financial products to hedge funds, pension funds, and institutional investors that often had higher margins. Looking at the chart above, many of these derivatives sold by Lehman Brothers and other investment banks were so complex in nature which could have only been valued and priced by learned people.
Regulators and traders often didn’t understand derivatives, and what the underlying assets really are. In this case, subprime mortgages. Therefore, without this creative packaging of financial securities, traders and regulators would have better understood the underlying risks that they are taking. It would simply be easier for them to identify that what they have on hand are high-risk subprime mortgages. This way, the warning signs could have been detected earlier when home owners started defaulting, causing banks to stop purchasing home mortgages, and the crisis could have been avoided.
Regular Review of the Ratings by Credit Rating Agencies
Sprinzen and Azarchs (2008) defended that Standard and Poor’s (S&P) the high credit rating of A+ for Lehman Brothers. They explained that the valuation of a company was based on historical performance of the company and as long as the ratings continued to reflect the prevailing market sentiment. A review of the rating would be undertaken only if there is a change in the market sentiment. Hence, Credit Rating Agencies such as S&P should continuously monitor the creditworthiness of the company and regularly re-rate the companies.
Managerial oversight & accounting standards
Claims from all over suggested that a good system to monitor activities of its executive committee should have been put in place. This could have involved critical auditing of the books of accounts to assess the true position of the firm. For instance, a report by the court appointed examiner did indicate that Lehman executives regularly used Repo 105 at the end of each quarter as cosmetic accounting gimmicks to make its finances appear less shaky than they really were. Such misleading information could have been revealed if a good system to account for re-purchase transactions were put in place. Consequently, Lehman Brothers could be pressured to reduce leverage in order to meet market expectations and avoid a ratings downgrade. Thus, the International Accounting Standards Board (IASB), Financial Accounting Standards Board (FASB) and senior bodies responsible for setting accounting standards, met in April 2010 to review the accounting treatment for such repo transactions.
Tightening of rules & Regulations
One of the reasons why Lehman Brothers fell so quickly was due to its high use of leverage to finance its investments in the housing market.
In the years leading up to the crisis, referring to the graph on the left, Lehman brothers were increasing their leverage in an attempt to capitalize on the housing market which was perceived to be booming. Near to its fall, it had a leverage of 31 to 1, much higher than other financial institutions. At that time, there were no specific regulations to prevent Lehman Brothers from doing so. In other words, most of its investments had little cash to back them up. Referring to the bar graph on the right, the amount of troubled assets it held were more than double its tangible equity. When the mortgage backed securities started defaulting, the bank found that it was not able to handle the losses as well as if they had a lower leverage.
Regulations could have been imposed on banks to set a maximum leverage ratio which they can use, for example 25 to 1. This will equip banks with more cash to back their investments as well as time to deal with the problem. In case of defaults and losses, the excess cash will allow banks to invest in other sources of income which might still be promising. In a way, the regulation would prevent banks from taking too much risk and allow them more time to deal with bad situations and rebound from them.
When Lehman Brothers went bankrupt, it stopped paying on its commercial paper, individuals and corporate treasurers alike rushed to withdraw their cash from money market funds all over. The funds, in turn, scrambled for cash and took back what money they could from banks on both sides of the Atlantic, freezing up lending everywhere. This caused great repercussions in the financial world. Many officials to this day argue that due to the lack of legal authority and funds, they had no choice but to let Lehman fail. Others argue that policymakers could have found a more creative way, had they wanted to. “In that kind of emergency, they could have found a way,” say Douglas Elliott, a former investment banker.13 (Francis, 2009)
The damage of the collapse on the entire economy was so strong that many wonder if the damage would have been lesser had the government intervened with bailouts and aids. Even if rescuing Lehman Brothers was not possible, allowing them to fall slowly would have given the world time to adjust rather than plunging straight into a full blown crisis. The true effects will never be known, however we believe the government could have adopted better measures to deal with the situation.
Shadow banking system
Shadow banks do not take deposits, thus they are subject to less regulation than traditional banks. They can therefore increase the rewards they get from investments by leveraging up much more than their mainstream counterparts and this can lead to risks mounting in the financial system. In Lehman Brothers case, they conducted many of their transactions in ways that do not show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investor. Thus, unregulated shadow institutions can be used to circumvent the strictly regulated mainstream banking system and avoid rules designed to prevent financial crises.
As such, many provisions should go towards regulating the shadow banking system such as the implementation of tighter credit and higher capital requirements. In 2010, the Dodd-Frank Act passed stipulates that the Federal Reserve System would have the power to regulate all institutions of systemic importance including shadow banks. Through these regulations, there would be greater transparency and requirements in the shadow banking system that could have prevented the bankruptcy of Lehman Brothers.
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